1. Business Combination involving Common Control Transactions
Enquiry:
Your valued opinion is sought about the following issue, guidance regarding which is presently not available in the IFRS:
A Company (the “Company) intends to issue 25 million ordinary shares to the general public at Rs.10 per share which is equal to 11.78% of its enhanced paid up capital.
An analysis of its prospectus has revalued that its paid up capital comprises 187.248 million shares of Rs.10 each out of which 9,900 shares are issued against cash while 187.239 million shares are issued against consideration otherwise than cash. These shares were issued pursuant to a scheme of arrangement between the Company and Company “A” whereby the company acquired net assets of Company “A” (except for one asset) worth Rs.552.753 million at a consideration of Rs.1,872.48 million resulting in creation of goodwill amounting to Rs.1,319 billion. The scheme was approved/ sanctioned by the High Court.
The said transfer was accounted for under the acquisition method laid down by IFRS-3 as applicable in Pakistan.
Analysis of shareholding:
Pre Combination:
Company “A” (Sponsor Company) is a private company limited by shares. The breakup of shareholding of Company “A” is as follows:
X Group 35%
Y Group 35%
Company D 30%
The Company was incorporated as a private company on December 4, 2008. The scheme of arrangement was signed between the Company and Company A on December 19, 2008. The breakup of shareholding of the Company on incorporation was as follows:
X Group 99%
Company A 1%
Post Combination
A joint petition was filed in High Court and the court sanctioned the said scheme vide order dated May 7, 2009. The Company converted to public limited company on September 16, 2009. Net assets along with three business of Company A stand transferred to the company. Under the scheme company D has been given 30% shareholding of the Company in lieu of transfer of its 30% shareholding in company A to X and Y Group in equal proportion. After the implementation of the scheme of arrangement the shareholding structure of the Company and Company A is as follows:
Company:
Company D 30%
Company A 70%
Company A:
X Group 50%
Y Group 50%
In the instant case shareholding of the business transferred to the Company from Company A remains the same before and after the scheme. From above it is clear that the transaction comes under the definition of a common control transaction as per IFRS 3 and the same is excluded from its scope. Basis for conclusions on IFRS 3 Business Combinations states that the consideration of the accounting for business combinations involving entities under common control is included in the second phase of the Business Combinations project of the IASB.
Commission’s concern:
The Commission, as a regulator of the capital markets, considers that recognition of substantial amount of goodwill on a business combination without any change of underlying ownership defeats the underlying concepts of the IFRS, particularly, wherein recognition of self-generated goodwill is expressly disallowed. It is also pertinent that fair valuation principles as laid down in IFRS 3 cannot remain as transparent in a common control transaction as they can be otherwise, indicating that purchase method is not appropriate for such transaction. Moreover, we would also like to point out that we have observed that other international jurisdictions, that can be referred to in the light of guidance given in IAS 8, including Hong Kong and US GAAP, require pooling method or predecessor values method of accounting for such combinations and we feel that the same can be stretched tour jurisdiction.
In view of above, our questions are as follows:
a) Whether or not, in spite of express scope exclusion from IFRS 3, has the above business combination been correctly accounted for under purchase method?
b) If the same is correct, will it be fair from the perspective of general public, to whom shares of a company having such a huge intangible asset are offered?
c) If otherwise, what should be the correct way of accounting for such a transaction?
d) Lastly, your opinion should address general scenario in Pakistan whereby distinction between management and sponsors cannot be made.
Opinion:
First of all, the Committee would like to thank you to highlight the important issue and appreciates your detailed analysis and concern thereon.
There is currently no specific guidance on accounting for common control transactions under IFRSs. However, in December 2007 the IASB added a project on this topic to its agenda. The project will examine the definition of common control and the methods of accounting for business combinations under common control in the acquirer’s consolidated and separate financial statements.
You have rightly mentioned in your enquiry that in the absence of specific guidance, entities involved in common control transactions may select an appropriate accounting policy using the ‘hierarchy’ described in paragraphs 10-12 of IAS 8 ‘Accounting Policies, Changes in Accounting Estimates and Errors’.
As the hierarchy permits the consideration of pronouncements of other standard-setting bodies, the guidance on group reorganisations in both UK and US GAAP may be useful in some circumstances. Such hierarchy of guidance states that in the absence of an accounting standard which specifically applies to a transaction, the management should consider the requirements of IFRS dealing with similar and related issues which in this case is IFRS 3 (that prescribes acquisition method of accounting). It is important to note that the reason for exclusion of common control transactions from IFRS 3 does not emanate from the fact that IASB considers purchase method as inappropriate for such transaction but for the reason that it intends to deal them separately.
Accordingly the Committee considers that both the methods i.e. acquisition method and pooling of interest method are equally acceptable internationally for such transactions depending on the accounting policy chosen by the management.
(May 2010)
2. Issue of Bonus Shares
Enquiry:
This in connection with accounting treatment, of excess of fair value over par value of shares to be issued upon amalgamation, under the purchase method prescribed by the International Financial reporting Standard – 3 (the “IFRS – 3”)
Company A and B entered into a duly sanctioned scheme of amalgamation. In consideration of amalgamation company A issued specified number of its shares to the shareholders of Company B. The amalgamation was accounted for applying the purchase method provided in IFRS – 3. Since the fair value of shares was determined to be higher than their par value, a reserve has been created to account for the difference. The Company is of the opinion that reserve thus created is in the nature of share premium account and the same can be used for the purpose of issuing bonus shares in terms of Section 83 of the Companies Ordinance, 1984 (“the Ordinance”).
The Commission is of the view that the said reserve, created due to excess of fair value over par value of shares in consequence of the said amalgamation, may be classified as merger reserve and cannot be classified as share premium reserve. Further since such reserve comes under the ambit of Rule 8 of the Companies Issue of Capital Rules 1996 therefore cannot be utilized for the purpose of issuing bonus shares in terms of Section 83 of the Ordinance.
You are requested to provide opinion:
a) as to whether this excess of fair value of shares over the par value can be classified as share premium reserve;
b) its accounting treatment is in accordance with the requirements of IFRS; and
c) the said reserve can be used for the purpose of issuing bonus keeping in view the requirements of the legal framework.
Opinion:
The International Financial Reporting Standard IFRS 3 ‘Business Combinations’ requires the application of purchase method of accounting for amalgamations/ business combinations that are within the scope of the standard. Under the purchase method of accounting, the consideration transferred, including in the form of issuance of shares in a business combination shall be measured at fair value notwithstanding the fact that the shares are actually issued at par value. As a result, when the fair value of the shares issued exceeds their nominal or par value, the difference is accounted for in the equity as a “capital reserve” and may even be classified as “share premium” and bonus shares may be issued from the amount credited to the share premium account. This runs contrary to the views expressed by the Commission in the aforesaid enquiry.
The Committee deliberated the issue at length and is of the view that in the absence of a clear stipulation under the Companies Ordinance, 1984 (the Ordinance) restricting the utilization of such “capital reserve” for distribution as bonus shares, a sustainable legal view can be taken that such “capital reserve” can be utilized for the said purpose. The Committee, therefore, is of the considered opinion that if the Commission intends to put restriction on the utilization of such “share premium reserve”, suitable amendments will be required in the Ordinance for which guidance may be taken from the English or Indian Law.
(July 2009)
3. Reserves on Amalgamation
Enquiry:
ABC Limited entered into a Scheme of Arrangement for Amalgamation (the Scheme) with DEF, then a 77.77% subsidiary of ABC as at July 1, 2004, the effective date of amalgamation. The Scheme was sanctioned by the Securities and Exchange Commission of Pakistan (SECP) on February 11, 2005.
The amalgamation was accounted for in the financial statements of ABC as a Uniting of Interests and accordingly all assets and liabilities of DEF were recorded at their pre-merger carrying values in accordance with the guidance specified in International Accounting Standard (IAS) 22: Business Combinations relating to the “pooling of interests” method. Under the Scheme, ABC Limited issued 700,000 fully paid-up ordinary shares of Rs.10 each to the registered shareholders of DEF (other than ABC) on the basis of a swap ratio of 1.4:1 i.e. 140 shares of ABC for every 100 shares held by these shareholders in DEF as consideration for the acquisition of shares of DEF. Consequent to issue of shares in accordance with the above swap ratio and under the “pooling of interests” method, a negative reserve of Rs. 2 million arose, representing the difference between the share capital issued to DEF, shareholders (other amalgamation, and the share capital of DEF, acquired under the scheme of amalgamation, and this negative reserve was separately classified in the statement of changes in equity as reserve on amalgamation.
Now we wish to remove this negative reserve from our books. We understand that paragraph 79 of IAS 22: Business Combinations permits the set off of any difference between the amount recorded as share capital issued plus any additional consideration in the form of cash or other assets and the amount recorded for the share capital in the equity. The equity is defined in the “Framework for the Preparation and Presentation of Financial Statements” as the residual interest in the assets of an entity after deducting all its liabilities. This residual interest may be sub-classified in the balance sheet as paid-up capital retained earnings and reserves which are created through appropriations of retained earnings etc.
On the contrary, the Fifth Schedule to the Companies Ordinance, 1984 which is applicable to financial statements of unlisted companies such as ABC, requires reserves to be classified separately as capital reserves and revenue reserves. Capital reserves specified in this Schedule include capital redemption reserve, share premium account, profit prior to incorporation or any reserve not regarded free for distribution by way of dividend while revenue reserve specified in this Schedule include general reserve dividend equalization reserve and other reserves created out of profit. In that respect this reserve appears to be a capital reserve, hence not available for distribution/ adjustment.
Having considered the above, we are looking for two options to remove the negative reserve on amalgamation from our books. Firstly, to set off the negative reserve from the accumulated profits available for distribution as permitted by IAS 22. Finally, the board of directors may appropriate Rs. 2 million from accumulated profits to the negatives reserve on amalgamation as we consider that there is no binding on appropriation from revenue reserve to capital reserve, for example appropriations from accumulated profits to reserve for issue of bonus share.
We trust the above explains the matter in detail enabling the Institute to issue an opinion on the appropriate treatment of negative reserve on amalgamation.
Opinion:
Your attention is drawn to the following paragraphs of Fourth and Fifth Schedules of the Companies Ordinance, 1984 relating to Capital Reserve:
Clause 2 (ii) of Part I of Fourth Schedule:
“capital reserve” includes capital redemption reserve, capital repurchase reserve account, share premium account, profit prior to incorporation or any reserve not regarded free for distribution by way of dividend.
Clause 6 of Part II of the Fourth Schedule:
Share capital and reserves shall be classified under the following sub-heads namely:-
(i) ………
(ii) Reserves, distinguishing between capital reserves and revenue reserves.
Clause 7(A) of Part II of the Fifth Schedule:
(i) ………………….
(ii) Reserves, distinguishing between capital reserves and revenue reserves, capital reserves shall include capital redemption reserve, share premium account, profit prior to incorporation or any reserve not regarded free for distribution, by way of dividend (to be specified), while revenue reserves shall include general reserve, dividend equalization reserve, other reserves created out of profit (to be specified), and unappropriated profit (i.e. credit balance of profit and loss account after appropriations for the period to the date of balance sheet). Additions to and deductions from each item of reserves shall be shown in the balance-sheet under the respective items unless they are disclosed in the profit and loss account or a statement or a report annexed thereto. Accumulated loss-adverse balance of profit and loss account shall be shown as deduction from the capital and reserves.
Though the above clauses of the Fourth and Fifth Schedules of the Companies Ordinance require reserves to be classified either as capital reserves or revenue reserves, no disclosure has been prescribed anywhere in the Companies Ordinance, 1984 where there is a negative reserve. In view of this the Committee is of the opinion that it would be appropriate to charge the negative reserves to retained earnings as required by the following paragraph of IAS 22, Business Combinations.
79. Any difference between the amount recorded as share capital issued plus any additional consideration in the form of cash or other assets and the amount recorded for the share capital acquired should be adjusted against equity.
(November 4, 2006)
4. Clarification on contradiction between IAS 22 and IAS 36
Enquiry:
ABC Fertilizer was incorporated in Pakistan as a private company limited by shares under Companies Ordinance, 1984, is engaged in manufacturing and selling of chemical fertilizers.
The company was privatized under privatization policy of Government of Pakistan on 14th July 2005 and 100% shareholding of ABC was acquired by XYZ, a company incorporated in Pakistan as a non-listed public company limited by shares. Management of ABC was handed over to XYZ on the said date.
Now amalgamation of XYZ and ABC has been proposed in a way that assets and liabilities of XYZ would be transferred to ABC. It would be a reverse merger. XYZ has paid consideration in excess of fair value of assets acquired which would generate positive Goodwill on amalgamation.
IAS 22, Business Combinations, IFRS 3, Business Combinations and IAS 36, Impairment of Assets, specify the accounting treatment of Goodwill. IAS 22 has been superseded by IFRS 3 but the said IFRS has not been adopted in Pakistan so far. Adoption of IFRS 3 internationally has, correspondingly revised requirements of IAS 36 Impairment of Assets. IAS 36 which is currently applicable in Pakistan and includes changes brought about by paragraph 54 of IFRS 3 which stipulates that subsequent to initial recognition, the acquirer shall measure goodwill acquired in a business combination at cost less any accumulated impairment loss. This is a deviation from the requirements of IAS 22 which specifies that Goodwill should be amortized.
As both the Standards i.e. IAS 22 and IAS 36 are applicable in Pakistan, the Committee’s opinion is solicited on the contradiction between requirements thereof.
Opinion:
The Committee is aware of the fact that the contradiction has arisen owing to the issuance of IFRS 3 Business Combinations and revised version of IAS 36 Impairment of Assets simultaneously. Though IAS 22 has been withdrawn by IASB, it is still in place in Pakistan since it has not been withdrawn by SECP through Gazette notification.
In view of the above the Committee is of the opinion that IAS 22 should be complied with until IFRS 3 becomes effective. However, as IAS 36 has been adopted in Pakistan and stipulates that goodwill should be tested for impairment annually (par. IN5 (c)), the Committee recommends that IAS 36 should also be complied with.
(May 6, 2006)